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CHAPTER 9 Monopoly H ow can a firm monopolize a market? Why aren’t most markets monopo-
CHAPTER
9
Monopoly
H
ow can a firm monopolize a market? Why aren’t most markets monopo-
lized? Why don’t most monopolies last? Why don’t monopolies charge the
highest possible price? Why do some firms offer discounts to students, senior citi-
zens, and other groups? Why are some airfares lower with a weekend stay? These and
other questions are answered in this chapter, which looks at our second market
structure—monopoly.
Monopoly is from the Greek, meaning “one seller.” In some parts of the United
States, monopolists sell electricity, cable TV service, and local phone service. Mo-
nopolists also sell postage stamps, hot dogs at sports arenas, some patented products,
and other goods and services with no close substitutes.You have probably heard
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194 Part 3 Market Structure and Pricing Net B ookmark For more information about patents—their purpose,
194
Part 3 Market Structure and Pricing
Net B ookmark
For more information about
patents—their purpose, what
can be patented, how to apply,
what rights are included—go to
the U.S. Patent and Trademark
Office’s Web page on General
Information Concerning Patents
at http://www.uspto.gov/web/
offices/pac/doc/general/. How
does the Patent Office treat the
information provided about a
new invention? Why do you
suppose that some firms prefer
not to seek patent protection for
new inventions? What types of
intellectual property, other than
new machines and processes,
can be protected by patents?
about the evils of monopoly.You may have even played the board game Monopoly on a rainy
day. Now we will sort out fact from fiction.
Like perfect competition, pure monopoly is not as common as other market structures.
But by understanding monopoly, you will grow more familiar with market structures that
lie between the extremes of perfect competition and pure monopoly.This chapter examines
the sources of monopoly power, how a monopolist maximizes profit, differences between
monopoly and perfect competition, and why a monopolist sometimes charges different
prices for the same product.Topics include:
Barriers to entry
Price elasticity and marginal
revenue
Profit maximization and
loss minimization
Monopoly and resource allocation
Welfare cost of monopoly
Price discrimination
The monopolist’s dream
Barriers to Entry
BARRIER TO ENTRY
Any impediment that prevents new
firms from entering an industry and
competing on an equal basis with
existing firms
As noted in Chapter 3, a monopoly is the sole supplier of a product with no close substitutes.
Why do some markets come to be dominated by a single supplier? A monopolized market
is characterized by barriers to entry, which are restrictions on the entry of new firms into
an industry. Because of barriers, new firms cannot profitably enter that market. Let’s exam-
ine three types of entry barriers: legal restrictions, economies of scale, and the monopolist’s
control of an essential resource.
Legal Restrictions
One way to prevent new firms from entering a market is to make entry illegal. Patents, li-
censes, and other legal restrictions imposed by the government provide some producers
with legal protection against competition.
Patents and Invention Incentives
PATENT
A legal barrier to entry that grants
its holder the exclusive right to sell
a product for 20 years from the
date the patent application is filed
INNOVATION
In the United States, a patent awards an inventor the exclusive right to produce a good or
service for 20 years from the date the patent is filed with the patent office. Originally en-
acted in 1790, patent laws encourage inventors to invest the time and money required to
discover and develop new products and processes. If others could simply copy successful
products, inventors would have less incentive to incur the up-front costs of invention.
Patents also provide the stimulus to turn inventions into marketable products, a process
called innovation.
The process of turning an invention
into a marketable product
Licenses and Other Entry Restrictions
Governments often confer monopoly status by awarding a single firm the exclusive right to
supply a particular good or service. Federal licenses give certain firms the right to broadcast
radio and TV signals. State licenses authorize suppliers of medical care, haircuts, and legal
advice.A license may not grant a monopoly, but it does block entry and often confers the
power to charge a price above the competitive level.Thus, a license can serve as an effective
barrier against new competitors. Governments also grant monopoly rights to sell hot dogs
at civic auditoriums, collect garbage, provide bus and taxi service, and supply services rang-
ing from electricity to cable TV.The government itself may claim that right by outlawing
Chapter 9 Monopoly 195 competitors. For example, many states sell liquor and lottery tickets, and the
Chapter 9 Monopoly
195
competitors. For example, many states sell liquor and lottery tickets, and the U.S. Postal Ser-
vice has the exclusive right to deliver first-class mail to your mailbox.
Economies of Scale
A monopoly sometimes occurs naturally when a firm experiences economies of scale, as re-
flected by the downward-sloping, long-run average cost curve shown in Exhibit 1. In such
instances, a single firm can supply market demand at a lower average cost per unit than
could two or more firms each producing less. Put another way, market demand is not great
enough to allow more than one firm to achieve sufficient economies of scale.Thus, a single
firm will emerge from the competitive process as the only supplier in the market. For ex-
ample, even though the production of electricity has become more competitive, the transmis-
sion of electricity still exhibits economies of scale. Once wires are run throughout a com-
munity, the marginal cost of linking additional households to the power grid is relatively
small. Consequently, the average cost of delivering electricity declines as more and more
households are wired into the system.
A monopoly that emerges from the nature of costs is called a natural monopoly, to distin-
guish it from the artificial monopolies created by government patents, licenses, and other
legal barriers to entry.A new entrant cannot sell enough to enjoy the economies of scale
enjoyed by an established natural monopolist, so market entry is naturally blocked.A later
chapter will discuss the regulation of natural monopolies.
Control of Essential Resources
Sometimes the source of monopoly power is a firm’s control over some re-
source critical to production. Here are four examples: (1) Alcoa was the sole
Economics in
the Movies
EXHIBIT
1
$
Economies of Scale as a
Barrier to Entry
A monopoly sometimes emerges
naturally when a firm experiences
economies of scale as reflected by a
downward-sloping, long-run average
cost curve. One firm can satisfy market
demand at a lower average cost per
unit than could two or more firms each
operating at smaller rates of output.
Long-run
average cost
Quantity
per period
Cost per unit
196 Part 3 Market Structure and Pricing U.S. maker of aluminum from the late 19th century
196
Part 3 Market Structure and Pricing
U.S. maker of aluminum from the late 19th century until World War II. Its monopoly power
initially stemmed from production patents that expired in 1909, but for the next three
decades, it controlled the supply of bauxite, the key raw material. (2) Professional sports
leagues try to block the formation of competing leagues by signing the best athletes to long-
term contracts and by seeking the exclusive use of sports stadiums and arenas. (3) China is a
monopoly supplier of pandas to the world’s zoos.The National Zoo in Washington, D.C.,
for example, rents its pair of pandas from China for $1 million a year.As a way of control-
ling the panda supply, China stipulates that any offspring from the pair becomes China’s
property. 1 Finally, (4) since the 1930s, the world’s diamond trade has been controlled pri-
marily by De Beers Consolidated Mines, which mines diamonds and also buys most of the
world’s supply of rough diamonds, as discussed in the following case study.
Is a Diamond Forever?
Case S tudy
World of Business
eActivity
At http://www.adiamondisforever.com ,
you can learn a lot about buying dia-
monds, but nothing about the sponsor-
ing firm—De Beers. For information
about the company check http://
www.debeersgroup.com. What are the
current prospects for De Beers’ grip on
the diamond market? De Beers is not
standing idly by while Canadian dia-
monds come into the market. The com-
pany has set up operations in Canada.
What have they accomplished there?
Find out at the De Beers Canada Web
site at http://www.debeerscanada.com.
In 1866, a child walking along the Orange River in
South Africa picked up an odd pebble that turned out
to be a 21-carat diamond. That discovery on a farm
owned by Johannes De Beers sparked the largest dia-
mond mine in history. Ever since the Great Depression
caused a slump in diamond prices, De Beers Consoli-
dated Mines has tried to control the world supply of
uncut diamonds.The company has kept prices high by
carefully limiting supply and by advertising. For exam-
ple, De Beers spent $183 million in 2003 trying to
convince people that diamonds are scarce, valuable, and
perfect reflections of love. One promotional coup was
to persuade Baywatch, a TV show now seen in reruns around the world, to devote an
episode to a diamond engagement ring.The story played up the De Beers line that the ring
should cost two months’ salary. An episode of The Drew Carey Show had a similar theme.
The latest attempt to boost the demand for diamonds is the “spirit ring,” a diamond worn
on a woman’s right hand as a sign of independence.
De Beers limits the supply of rough diamonds reaching the market.The company, which
is sometimes called “The Syndicate,” invites about one hundred wholesalers to London,
where each is offered a box of uncut diamonds for a set price—no negotiating. If De Beers
needs to prop up the price of a certain size and quality of diamond, then few of those will
show up in the boxes, thus restricting their supply.The company’s actions violate U.S. an-
titrust laws (De Beers executives could be arrested if they traveled to America). But there
are no laws prohibiting U.S. wholesalers from buying from De Beers.
It might surprise you that, as gems go, diamonds are not especially rare, either in nature
or in jewelry stores. Diamonds may be the most common natural gemstone. Jewelry stores
sell more diamonds than any other gem. Jewelers are willing to hold large inventories because
they are confident that De Beers will keep prices up. De Beers’ slogan,“A diamond is forever,”
sends several messages, including (1) a diamond lasts forever, and so should love; (2) diamonds
should remain in the family and not be sold; and (3) diamonds retain their value.This slogan is
aimed at keeping secondhand diamonds,which are good substitutes for new ones,off the mar-
ket, where they could otherwise increase supply and drive down the price.
But De Beers has recently lost control of some rough diamond supplies. Russian miners
have been selling half their diamonds to independent dealers.Australia’s Argyle mine, now
1. Francis Clines, “Capital Exults Over Pandas,” New York Times, 7 December 2000.
© Peter Kaskons/Index Stock Imagery

Chapter 9 Monopoly

the world’s largest, stopped selling to De Beers in 1996.And Yellowknife, a huge Canadian mine, began operations in 1998, but De Beers is guaranteed only about one-third of its out- put. As a result of all this erosion, DeBeers’ share of the world’s uncut diamond supply slipped from nearly 90 percent in the mid-1980s to about 62 percent in 2002.Worse still for De Beers, newly developed synthetic diamonds are starting to appear on the market.To counter that threat, De Beers is supplying precision equipment to jewelers so they can spot synthetic diamonds. A monopoly that relies on the control of a key resource, as De Beers does, loses its power once that control slips away. In a reversal of policy, De Beers now says it will abandon efforts to control the world diamond supply and will instead become the “supplier of choice” by promoting the DeBeers brand of diamonds. But as of 2004 there are only a few DeBeers retail stores worldwide, in London and in Tokyo. De Beers is now trying to settle U.S. an- titrust charges so it can open stores in the states. (Americans account for only 5 percent of the world’s population but for half the world’s diamond purchases.) In an effort to differen- tiate its diamonds, De Beers is etching the company name and an individual security num- ber on some diamonds.Whether this branding effort will work remains to be seen.

Sources: Phyllis Berman and Lea Goldman, “The Billionaire Who Cracked De Beers,” Forbes, 15 September 2003; Rob Walker, “The Right-Hand Diamond Ring,” New York Times, 4 January 2004; Joshua Davis, “The New Diamond Age,” Wired Magazine, September 2003; John Wilke, “De Beers Is in Talks to Settle Charges of Price Fixing,” Wall Street Journal, 24 February 2004; and the De Beers home page at http://www.adiamondisforever.com/.

Local monopolies are more common than national or international monopolies. In rural areas, monopolies may include the only grocery store, movie theater, or restaurant for miles around.These are natural monopolies for products sold in local markets. But long-lasting mo- nopolies are rare because, as we will see, a profitable monopoly attracts competitors.Also, over time, technological change tends to break down barriers to entry. For example, the develop- ment of wireless transmission of long-distance calls created competitors to AT&T.Wireless transmission will soon erase the monopoly held by local cable TV providers and even local phone service. Likewise, fax machines, email, the Internet, and firms such as FedEx now com- pete with the U.S. Postal Service’s monopoly, as we will see in a later case study.

Revenue for the Monopolist

Because a monopoly, by definition, supplies the entire market, the demand for goods or services pro- duced by a monopolist is also the market demand.The demand curve for the monopolist’s output therefore slopes downward, reflecting the law of demand—price and quantity demanded are inversely related. Let’s look at demand, average revenue, and marginal revenue.

Demand, Average Revenue, and Marginal Revenue

Suppose De Beers controls the entire diamond market. Exhibit 2 shows the demand curve for 1-carat diamonds. De Beers, for example, can sell three diamonds a day at $7,000 each. That price-quantity combination yields total revenue of $21,000 (=$7,000 3 3).Total rev- enue divided by quantity is the average revenue per diamond, which also is $7,000.Thus, the monopolist’s price equals the average revenue per unit.To sell a fourth diamond, De Beers must drop the price to $6,750.Total revenue for four diamonds is $27,000 (=$6,750 3 4) and average revenue is $6,750.All along the demand curve, price equals average revenue. Therefore, the demand curve is also the monopolist’s average revenue curve, just as the perfectly competitive firm’s demand curve is that firm’s average revenue curve.

198 Part 3 Market Structure and Pricing EXHIBIT 2 $7,000 Loss 6,750 A Monopolist’s Gain and
198
Part 3 Market Structure and Pricing
EXHIBIT
2
$7,000
Loss
6,750
A Monopolist’s Gain and
Loss in Total Revenue from
Selling One More Unit
D = Average revenue
If De Beers increases quantity supplied
from 3 to 4 diamonds per day, the gain
in revenue from the fourth diamond is
$6,750. But the monopolist loses $750
from selling the first 3 diamonds for
$6,750 each instead of $7,000 each.
Marginal revenue from the fourth dia-
mond equals the gain minus the loss, or
$6,750 – $750 = $6,000. Thus, the mar-
ginal revenue of $6,000 is less than the
price of $6,750.
Gain
0
3
4
1–carat diamonds per day
What’s the monopolist’s marginal revenue from selling a fourth diamond? When De
Beers drops the price from $7,000 to $6,750, total revenue goes from $21,000 to $27,000.
Thus, marginal revenue—the change in total revenue from selling one more diamond—is
$6,000, which is less than the price, or average revenue, of $6,750. For a monopolist, marginal
revenue is less than the price, or average revenue. Recall that for a perfectly competitive firm,
marginal revenue equals the price, or average revenue, because that firm can sell all it wants
to at the market price.
The Gains and Loss from Selling One More Unit
A closer look at Exhibit 2 reveals why a monopolist’s marginal revenue is less than the price.
By selling another diamond, De Beers gains the revenue from that sale. For example, De
Beers gets $6,750 from the fourth diamond, as shown by the blue-shaded vertical rectangle
marked “Gain.” But to sell that fourth unit, De Beers must sell all four diamonds for $6,750
each.Thus, to sell a fourth diamond, De Beers must sacrifice $250 on each of the first three
diamonds, which could have been sold for $7,000 each.This loss in revenue from the first
three units totals $750 (=$250 3 3) and is identified in Exhibit 2 by the pink-shaded hori-
zontal rectangle marked “Loss.”The net change in total revenue from selling the fourth dia-
mond—that is, the marginal revenue from the fourth diamond—equals the gain minus the
loss, which equals $6,750 minus $750, or $6,000. So marginal revenue equals the gain minus
the loss, or the price minus the revenue forgone by selling all units for a lower price. Be-
cause a monopolist’s marginal revenue equals the price minus the loss, you can see why the
price exceeds marginal revenue.
Incidentally, this analysis assumes that all units of the good are sold at the market price;
for example, the four diamonds are sold for $6,750 each.Although this is usually true, later
in the chapter you will learn how some monopolists try to increase profit by charging dif-
ferent customers different prices.
Dollars per diamond
Chapter 9 Monopoly 199 EXHIBIT 3 (1) (2) (3) (4) 1-Carat Diamonds Price per Day (average
Chapter 9 Monopoly
199
EXHIBIT
3
(1)
(2)
(3)
(4)
1-Carat Diamonds
Price
per Day
(average revenue)
Total Revenue
(TR 5 p 3 Q)
Marginal Revenue
(MR 5 ∆TR/∆Q)
(Q)
(p)
0
$7,750
0
____
Revenue for De Beers,
a Monopolist
1
7,500
$ 7,500
$7,500
2
7,250
14,500
7,000
3
7,000
21,000
6,500
4
6,750
27,000
6,000
5
6,500
32,500
5,500
6
6,250
37,500
5,000
7
6,000
42,000
4,500
To sell more, the monopolist must lower
the price on all units sold. Because the
revenue lost from selling all units at a
lower price must be subtracted from
the revenue gained by selling another
unit, marginal revenue is less than the
price. At some point, marginal revenue
turns negative, as shown here when the
price is reduced to $3,500.
8
5,750
46,000
4,000
9
5,500
49,500
3,500
10
5,250
52,500
3,000
11
5,000
55,000
2,500
12
4,750
57,000
2,000
13
4,500
58,500
1,500
14
4,250
59,500
1,000
15
4,000
60,000
500
16
3,750
60,000
0
17
3,500
59,500
–500
Revenue Schedules
Let’s flesh out more fully the revenue schedules behind the demand curve of Exhibit 2. Col-
umn (1) of Exhibit 3 lists the quantity of diamonds demanded per day, and column (2) lists
the corresponding price, or average revenue.The two columns together are the demand
schedule facing De Beers for 1-carat diamonds.The price in column (2) times the quantity
in column (1) yields the monopolist’s total revenue, shown in column (3). So TR = p 3 Q.
As De Beers expands output, total revenue increases until quantity reaches 15 diamonds.
Marginal revenue, the change in total revenue from selling one more diamond, appears in
column (4). In shorthand, MR = ∆TR/∆Q, or the change in total revenue divided by the
change in quantity. Note in Exhibit 3 that after the first unit, marginal revenue is less than
price.As the price declines, the gap between price and marginal revenue widens because
the loss from selling all diamonds for less increases (because quantity increases) and the gain
from selling another diamond decreases (because the price falls).
Revenue Curves
The data in Exhibit 3 are graphed in Exhibit 4, which shows the demand and marginal rev-
enue curves in panel (a) and the total revenue curve in panel (b). Recall that total revenue
equals price times quantity. Note that the marginal revenue curve is below the demand curve and
200 Part 3 Market Structure and Pricing EXHIBIT 4 (a) Demand and marginal revenue Monopoly Demand
200
Part 3 Market Structure and Pricing
EXHIBIT
4
(a) Demand and marginal revenue
Monopoly Demand and
Marginal Total Revenue
Elastic
Where demand is price elastic, mar-
ginal revenue is positive, so total rev-
enue increases as the price falls.
Where demand is price inelastic, mar-
ginal revenue is negative, so total rev-
enue decreases as the price falls.
Where demand is unit elastic, marginal
revenue is zero, so total revenue is at
a maximum, neither increasing nor
decreasing.
Unit elastic
$3,750
Inelastic
0
D = Average revenue
Marginal revenue
16
32
1-carat diamonds
per day
(b) Total revenue
$60,000
Total revenue
0
16
32
1-carat diamonds
per day
that total revenue reaches a maximum when marginal revenue reaches zero.Take a minute now to
study these relationships—they are important.
Again, at any level of sales, price equals average revenue, so the demand curve is also the
monopolist’s average revenue curve. In Chapter 5 you learned that the price elasticity for a
Total dollars
Dollars per diamond
Chapter 9 Monopoly 201 straight-line demand curve decreases as you move down the curve.When demand is
Chapter 9 Monopoly
201
straight-line demand curve decreases as you move down the curve.When demand is elas-
tic—that is, when the percentage increase in quantity demanded more than offsets the per-
centage decrease in price—a decrease in price increases total revenue.Therefore, where de-
mand is elastic, marginal revenue is positive, and total revenue increases as the price falls. On the
other hand, where demand is inelastic—that is, where the percentage increase in quantity
demanded is less than the percentage decrease in price—a decrease in price reduces total
revenue. In other words, the loss in revenue from selling all diamonds for the lower price
overwhelms the gain in revenue from selling more diamonds.Therefore, where demand is in-
elastic, marginal revenue is negative, and total revenue decreases as the price falls.
From Exhibit 4, you can see that marginal revenue turns negative if the price drops be-
low $3,750, indicating inelastic demand below that price. A profit-maximizing monopolist
would never willingly expand output to where demand is inelastic because doing so would reduce total
revenue. It would make no sense to sell more just to see total revenue drop. Also note that
demand is unit elastic at the price of $3,750.At that price, marginal revenue is zero and to-
tal revenue reaches a maximum.
The Firm’s Costs and Profit Maximization
In the case of perfect competition, each firm’s choice is confined to quantity because the
market already determines the price.The perfect competitor is a price taker. The monopolist,
however, can choose either the price or the quantity, but choosing one determines the
other—they come in pairs. For example, if De Beers decides to sell 10 diamonds a day, con-
sumers would buy that many only at a price of $5,250.Alternatively, if De Beers decides to
sell diamonds for $6,000 each, consumers would buy 7 a day at that price. Because the mo-
nopolist can select the price that maximizes profit, we say the monopolist is a price maker.
More generally, any firm that has some control over what price to charge is a price maker.
PRICE MAKER
Profit Maximization
Exhibit 5 repeats the revenue data from Exhibits 3 and 4 and also includes short-run cost
data reflecting costs similar to those already introduced in the two previous chapters.Take a
little time now to become familiar with this table.Then ask yourself, which price-quantity
combination should De Beers select to maximize profit? As was the case with perfect com-
petition, the monopolist can approach profit maximization in two ways—the total approach
and the marginal approach.
A firm that must find the profit-
maximizing price when the demand
curve for its output slopes
downward
Total Revenue Minus Total Cost
The profit-maximizing monopolist employs the same decision rule as the competitive firm.
The monopolist produces the quantity at which total revenue exceeds total cost by the greatest amount.
Economic profit appears in column (8) of Exhibit 5.As you can see, the maximum profit is
$12,500 per day, which occurs when output is 10 diamonds per day and the price is $5,250
per diamond.At that quantity, total revenue is $52,500 and total cost is $40,000.
Marginal Revenue Equals Marginal Cost
De Beers, as a profit-maximizing monopolist, increases output as long as selling more dia-
monds adds more to total revenue than to total cost. So De Beers expands output as long as
marginal revenue, shown in column (4) of Exhibit 5, exceeds marginal cost, shown in col-
umn (6). But De Beers will stop short of where marginal cost exceeds marginal revenue.
Again, profit is maximized at $12,500 when output is 10 diamonds per day. For the 10th di-
amond, marginal revenue is $3,000 and marginal cost is $2,750.As you can see, if output
202 Part 3 Market Structure and Pricing EXHIBIT 5 Short-Run Costs and Revenue for a Monopolist
202
Part 3 Market Structure and Pricing
EXHIBIT
5
Short-Run Costs and Revenue for a Monopolist
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
Diamonds
Price
per Day
(p)
Total
Revenue
Marginal
Revenue
Total
Marginal
Average
Total
Cost
Cost
Total Cost
Profit or
(Q)
(TR 5 p 3 Q)
(MR 5∆TR /∆Q)
(TC)
(MC 5 ∆TC /∆Q) (ATC 5 TC/Q) Loss (5TR 2 TC)
0
$7,750
0
____
$15,000
____
____
–$15,000
1
7,500
$7,500
$7,500
19,750
$4,750
$19,750
–12,250
2
7,250
14,500
7,000
23,500
3,750
11,750
–9,000
3
7,000
21,000
6,500
26,500
3,000
8,833
–5,500
4
6,750
27,000
6,000
29,000
2,500
7,750
–2,000
5
6,500
32,500
5,500
31,000
2,000
6,200
1,500
6
6,250
37,500
5,000
32,500
1,500
5,417
5,000
7
6,000
42,000
4,500
33,750
1,250
4,821
8,250
8
5,750
46,000
4,000
35,250
1,500
4,406
10,750
9
5,500
49,500
3,500
37,250
2,000
4,139
12,250
10
5,250
52,500
3,000
40,000
2,750
4,000
12,500
11
5,000
55,000
2,500
43,250
3,250
3,932
11,750
12
4,750
57,000
2,000
48,000
4,750
4,000
9,000
13
4,500
58,500
1,500
54,500
6,500
4,192
4,000
14
4,250
59,500
1,000
64,000
9,500
4,571
–4,500
15
4,000
60,000
500
77,500
13,500
5,167
–17,500
16
3,750
60,000
0
96,000
18,500
6,000
–36,000
17
3,500
59,500
–500
121,000
25,000
7,117
–61,500
exceeds 10 diamonds per day, marginal cost exceeds marginal revenue.An 11th diamond’s
marginal cost of $3,250 exceeds its marginal revenue of $2,500. For simplicity, we say that
the profit-maximizing output occurs where marginal revenue equals marginal cost, which, you will
recall, is the golden rule of profit maximization.
Graphical Solution
The cost and revenue data in Exhibit 5 are graphed in Exhibit 6, with per-unit cost and rev-
enue curves in panel (a) and total cost and revenue curves in panel (b).The intersection of
the two marginal curves at point e in panel (a) indicates that profit is maximized when 10 di-
amonds are sold.At that quantity, we move up to the demand curve to find the profit-maxi-
mizing price of $5,250.The average total cost of $4,000 is identified by point b. The average
profit per diamond equals the price of $5,250 minus the average total cost of $4,000. Eco-
nomic profit is the average profit per unit of $1,250 multiplied by the 10 diamonds sold, for
a total profit of $12,500 per day, as identified by the shaded rectangle. So the profit-maximizing
rate of output is found where the rising marginal cost curve intersects the marginal revenue curve.
Chapter 9 Monopoly 203 EXHIBIT 6 (a) Per-unit cost and revenue Marginal cost Average total cost
Chapter 9 Monopoly
203
EXHIBIT
6
(a) Per-unit cost and revenue
Marginal cost
Average total cost
Monopoly Costs and
Revenue
a
$5,250
Profit
b
4,000
e
D = Average revenue
MR
0
10
16
32
Diamonds per day
(b) Total cost and revenue
A profit-maximizing monopolist supplies
10 diamonds per day and charges
$5,250 per diamond. Total profit, shown
by the blue rectangle in panel (a), is
$12,500, the profit per unit multiplied by
the number of units sold. In panel (b),
profit is maximized where total revenue
exceeds total cost by the greatest
amount, which occurs at an output rate
of 10 diamonds per day. Maximum profit
is total revenue ($52,500) minus total
cost ($40,000), or $12,500. In panel (a)
profit is measured by an area and in
panel (b) it’s measured by a vertical dis-
tance. That’s because panel (a) mea-
sures cost, revenue, and profit per unit
of output and panel (b) measures them
as totals.
Total cost
Maximum
profit
$52,500
40,000
Total revenue
15,000
0
10
16
32
Diamonds per day
In panel (b), the firm’s profit or loss is measured by the vertical distance between the to-
tal revenue and total cost curves. De Beers will expand output as long as the increase in to-
tal revenue from selling one more diamond exceeds the increase in total cost. The profit-max-
imizing firm will produce where total revenue exceeds total cost by the greatest amount. Again, profit
is maximized where De Beers sells 10 diamonds per day. Note again that in panel (b), total
profit is measured by the vertical distance between the two total curves, and in panel (a), total
Total dollars
Dollars per unit
  • 204 Part 3 Market Structure and Pricing profit is measure by the shaded area formed by multiplying average profit per unit by the number of units sold. One common myth about monopolies is that they charge the highest price possible. But the monopolist is interested in maximizing profit, not price.The monopolist’s price is lim- ited by consumer demand. De Beers, for example, could charge $7,500 but would sell only one diamond at that price and would lose money. Indeed, De Beers could charge $7,750 or more but would sell no diamonds. So charging the highest possible price is not consistent with maximizing profit. Short-Run Losses and the Shutdown Decision A monopolist is not assured a profit.Although a monopolist is the sole supplier of a good with no close substitutes, the demand for that good may not generate economic profit in either the short run or the long run.After all, many new products are protected from direct competition by patents, yet most patents never turn into a profitable product.And even a monopolist that is initially profitable may eventually suffer losses because of rising costs, falling demand, or market entry of similar products. For example, Coleco, the original mass producer of Cabbage Patch dolls, went bankrupt after that craze died down.And Cuisinart,

the company that introduced the food processor in the early 1980s, soon faced many imita- tors and filed for bankruptcy before the end of the decade (though its name lives on). In the short run, the loss-minimizing monopolist, like the loss-minimizing perfect competitor, must decide whether to produce or to shut down. If the price covers average variable cost, the firm will produce. If not, the firm will shut down, at least in the short run.

Exhibit 7 brings average variable cost back into the picture. Recall from Chapter 7 that average variable cost and average fixed cost sum to average total cost. Loss minimization oc-

curs in Exhibit 7 at point e, where the marginal revenue curve intersects the marginal cost curve.At the equilibrium rate of output, Q, price p is found on the demand curve at point b.That price exceeds average variable cost, at point c, but is below average total cost, at point a. Because price covers average variable cost and makes some contribution to average fixed cost, this monopolist loses less by producing Q than by shutting down.The average loss per unit, measured by a b, is average total cost minus average revenue, or price.The loss, identi- fied by the shaded rectangle, is the average loss per unit, a b, times the quantity sold, Q. The firm will shut down in the short run if the average variable cost curve is above the demand curve, or average revenue curve, at all output rates. Recall that a perfectly competitive firm’s supply curve is that portion of the marginal cost curve at or above the average variable cost curve.The intersection of a monopolist’s marginal revenue and marginal cost curves identifies the profit-maximizing (or loss-mini- mizing) quantity, but the price is found up on the demand curve. Because the equilibrium quantity can be found along a monopolist’s marginal cost curve, but the equilibrium price appears on the demand curve, no single curve shows both price and quantity supplied. Be- cause no curve reflects combinations of price and quantity supplied, there is no monopolist supply curve.

Long-Run Profit Maximization

For perfectly competitive firms, the distinction between the short run and the long run is important because entry and exit of firms can occur in the long run, erasing any economic profit or loss. For the monopolist, the distinction between the short run and long run is less important. If a monopoly is insulated from competition by high barriers that block new entry, eco- nomic profit can persist in the long run. Yet short-run profit is no guarantee of long-run profit.

Chapter 9 Monopoly 205 EXHIBIT 7 Marginal cost The Monopolist Minimizes Losses in the Short Run
Chapter 9 Monopoly
205
EXHIBIT
7
Marginal cost
The Monopolist Minimizes
Losses in the Short Run
a
Average total cost
Marginal revenue equals marginal cost
at point e. At quantity Q, price p (at
point b) is less than average total cost
(at point a), so the monopolist suffers a
loss, identified by the pink rectangle.
But the monopolist will continue to pro-
duce rather than shut down in the short
run because price exceeds average
variable cost (at point c).
Loss
b
p
Average variable cost
c
e
Demand = Average revenue
Marginal revenue
0
Q
Quantity per period
For example, suppose the monopoly relies on a patent. Patents last only so long and even
while its product is under patent, the monopolist often must defend it in court (patent liti-
gation has increased more than half in the last decade). On the other hand, a monopolist
may be able to erase a loss (most start-up firms lose money initially) or increase profit in the
long run by adjusting the scale of the firm or by advertising to increase demand.A monop-
olist unable to erase a loss will leave the market.
Monopoly and the Allocation of Resources
If monopolists are no greedier than perfect competitors (because both maximize profit),
if monopolists do not charge the highest possible price, and if monopolists are not guaran-
teed a profit, then what’s the problem with monopoly? To get a handle on the problem,
let’s compare monopoly with the benchmark established in the previous chapter—perfect
competition.
Price and Output Under Perfect Competition
Let’s begin with the long-run equilibrium price and output for a perfectly competitive mar-
ket. Suppose the long-run market supply curve in perfect competition is horizontal, as
shown by S c in Exhibit 8. Because this is a constant-cost industry, the horizontal long-run
supply curve also shows marginal cost and average total cost at each quantity. Equilibrium
occurs at point c, where market demand and market supply curves intersect to yield price p c
and quantity Q c . Remember, the demand curve reflects the marginal benefit of each unit
purchased. In competitive equilibrium, the marginal benefit equals the marginal cost to
Dollars per unit
206 Part 3 Market Structure and Pricing EXHIBIT 8 a Perfect Competition and Monopoly m p
206
Part 3 Market Structure and Pricing
EXHIBIT
8
a
Perfect Competition and
Monopoly
m
p m
A perfectly competitive industry would
produce output Q c , determined by the
intersection of the market demand
curve D and the market supply curve S c .
The price would be p c . A monopoly that
could produce output at the same mini-
mum average cost as a perfectly com-
petitive industry would produce output
Q m , determined at point b, where mar-
ginal cost and marginal revenue inter-
sect. The monopolist would charge
price p m . Thus, given the same costs,
output is lower and price is higher
under monopoly than under perfect
competition.
b
c
p
c
S c = MC = ATC
D = AR
MR
m
0
Quantity per period
Q m
Q c
society of producing the final unit sold.As noted in the previous chapter, when the mar-
ginal benefit that consumers derive from a good equals the marginal cost of producing that
good, that market is said to be allocatively efficient and to maximize social welfare.There is
no way of reallocating resources to increase the total value of output or to increase social
welfare. Because consumers are able to purchase Q c units at price p c , they enjoy a net benefit
from consumption, or a consumer surplus, measured by the entire shaded triangle, acp c .
Price and Output Under Monopoly
When there is only one firm in the industry, the industry demand curve becomes the mo-
nopolist’s demand curve, so the price the monopolist charges determines how much gets
sold. Because the monopolist’s demand curve slopes downward, the marginal revenue curve
also slopes downward and is beneath the demand curve, as is indicated by MR
in Exhibit
m
8. Suppose the monopolist can produce at the same constant cost in the long run as can the
competitive industry.The monopolist maximizes profit by equating marginal revenue with
marginal cost, which occurs at point b, yielding equilibrium price p m and output Q m .Again,
the price shows the consumers’ marginal benefit for unit Q m .This marginal benefit, identi-
fied at point m, exceeds the monopolist’s marginal cost, identified at point b. Because mar-
ginal benefit exceeds marginal cost, society would be better off if output were expanded
beyond Q m .The monopolist restricts quantity below what would maximize social welfare.
Even though the monopolist restricts output, consumers still derive some benefit; consumer
surplus is shown by the smaller triangle, a mp m .
Allocative and Distributive Effects
Consider the allocative and distributive effects of monopoly versus perfect competition. In
Exhibit 8, consumer surplus under perfect competition was the large triangle, acp c . Under
Dollars per unit
Chapter 9 Monopoly 207 monopoly, consumer surplus shrinks to the smaller triangle amp m , which
Chapter 9 Monopoly
207
monopoly, consumer surplus shrinks to the smaller triangle amp m , which in this example is
only one-fourth as large.The monopolist earns economic profit equal to the shaded rectan-
gle. By comparing the situation under monopoly with that under perfect competition, you
can see that the monopolist’s economic profit comes entirely from what was consumer sur-
plus under perfect competition. Because the profit rectangle reflects a transfer from con-
sumer surplus to monopoly profit, this amount is not lost to society and so is not consid-
ered a welfare loss.
Notice, however, that consumer surplus has been reduced by more than the profit rec-
tangle. Consumers have also lost the triangle mcb, which was part of the consumer surplus
under perfect competition.The mcb triangle is called the deadweight loss of monopoly
because it is a loss to consumers but a gain to nobody.This loss results from the allocative in-
efficiency arising from the higher price and reduced output of monopoly.Again, society would be
better off if output exceeded the monopolist’s profit-maximizing quantity, because the mar-
ginal benefit of more output exceeds its marginal cost. Under monopoly, the price, or mar-
ginal benefit, always exceeds marginal cost. Empirical estimates of the annual deadweight
loss of monopoly in the United States range from about 1 percent to about 5 percent of na-
tional income.Applied to national income data for 2004, these estimates imply a deadweight
loss ranging from about $400 to $2,000 per capita, not a trivial amount.
DEADWEIGHT LOSS
OF MONOPOLY
Net loss to society when a firm
uses its market power to restrict
output and increase price
Problems Estimating the Deadweight Loss of Monopoly
The actual cost of monopoly could differ from the deadweight loss described above.These
costs could be lower or higher. Here’s the reasoning.
Why the Deadweight Loss of Monopoly Might Be Lower
If economies of scale are substantial enough, a monopolist might be able to produce output
at a lower cost per unit than could competitive firms.Therefore, the price, or at least the
cost of production, could be lower under monopoly than under competition.The dead-
weight loss shown in Exhibit 8 may also overstate the true cost of monopoly because mo-
nopolists might, in response to public scrutiny and political pressure, keep prices below what
the market could bear.Although monopolists would like to earn as much profit as possible,
they realize that if the public outcry over high prices and high profit grows loud enough,
some sort of government intervention could reduce or even erase that profit. For example,
the prices and profit of drug companies, which individually are monopoly suppliers of
patented medicines, come under scrutiny from time to time by federal legislators who want
to regulate drug prices. Drug firms might try to avoid such treatment by keeping prices be-
low the level that would maximize profit. Finally, a monopolist might keep the price below
the profit-maximizing level to avoid attracting new competitors to the market. For exam-
ple, some observers claim that Alcoa, when it was the only U.S. producer of aluminum, kept
prices low enough to discourage new entry.
Why the Deadweight Loss Might Be Higher
Another line of reasoning suggests that the deadweight loss of monopoly might, in fact, be
greater than shown in our simple diagram. If resources must be devoted to securing and maintain-
ing a monopoly position, monopolies may involve more of a welfare loss than simple models suggest.
For example, radio and TV broadcasting rights confer on the recipient the use a particular
band of the scarce broadcast spectrum. In the past, these rights have been given away by
government agencies to the applicants deemed most deserving. Because these rights are so
208 Part 3 Market Structure and Pricing RENT SEEKING Activities undertaken by individuals or firms to
208
Part 3 Market Structure and Pricing
RENT SEEKING
Activities undertaken by individuals
or firms to influence public policy
in a way that will increase their
incomes
valuable, numerous applicants spend millions on lawyers’ fees, lobbying expenses, and other
costs associated with making themselves appear the most deserving.The efforts devoted to
securing and maintaining a monopoly position are largely a social waste because they use
up scarce resources but add not one unit to output.Activities undertaken by individuals or
firms to influence public policy in a way that will directly or indirectly redistribute income
to them are referred to as rent seeking.
The monopolist, insulated from the rigors of competition in the marketplace, might also
grow fat and lazy—and become inefficient. Because some monopolies could still earn an
economic profit even if the firm is inefficient, corporate executives might waste resources
creating a more comfortable life for themselves. Long lunches, afternoon golf, plush offices,
corporate jets, and extensive employee benefits might make company life more pleasant, but
they increase the cost of production and raise the price.
Monopolists have also been criticized for being slow to adopt the latest production tech-
niques, being reluctant to develop new products, and generally lacking innovation. Because
monopolists are largely insulated from the rigors of competition, they might take it easy. It’s
been said “The best of all monopoly profits is a quiet life.”
The following case study discusses the performance of one of the nation’s oldest monop-
olies, the U.S. Postal Service.
The Mail Monopoly
Case S tudy
Public Policy
eActivity
How has the U.S. Postal Service
dealt with competition and change?
A chapter in its online history, at
http://www.usps.com/history/his3_5.
htm, describes the reforms made in the
1990s to compete with for-profit firms
and email. How does the Postal Service
set rates now that it is no longer a
monopoly? The process is described
at http://www.usps.com/ratecase/
how_rates.htm. What role do forces of
competition play in rate setting? Online
cost calculators are provided by both
USPS at http://postcalc.usps.gov/ and
UPS (United Parcel Service) at
http://wwwapps.ups.com/QCC
WebApp/request . Try finding the cost
of sending a letter to Uruguay. Which is
cheaper—USPS or UPS? Why?
The U.S. Post Office was granted a monopoly in 1775
and has operated under federal protection ever since. In
1971, Congress converted the Post Office Department
into a semi-independent agency called the U.S. Postal
Service, or USPS, with total revenue of about $70 bil-
lion in 2003.About 800,000 USPS employees handle
more than half a billion pieces of mail a day—over 40
percent of the world’s total. USPS pays no taxes and is
exempt from local zoning laws. It has a legal monopoly
in delivering regular, first-class letters and has the ex-
clusive right to use the space inside your mailbox. Out-
fits like FedEx or UPS cannot deliver to mail boxes or post office boxes.
The USPS monopoly has suffered in recent years because of rising costs and stiff compe-
tition from new technologies.The price of a first-class stamp climbed from 6 cents in 1970
to 37 cents by 2003—a growth rate double that of inflation. Long-distance phone service,
one possible substitute for first-class mail, has become cheaper since 1970. New technolo-
gies such as fax machines and email also compete with USPS (email messages now greatly
outnumber first-class letters). Because the monopoly applies only to regular first-class mail,
USPS has lost chunks of other business to private firms offering lower rates and better ser-
vice.The United Parcel Service (UPS) is more mechanized and more containerized than
the USPS and thus has lower costs and less breakage.The USPS has tried to emulate UPS
but with only limited success. Postal employees are paid more on average than those at UPS
or other private-sector delivery services, such as FedEx.
When the Postal Service raised third-class (“junk” mail) rates, businesses substituted other
forms of advertising, including cable TV and telemarketing. UPS and other rivals now ac-
count for 75 percent of the ground-shipped packages. Even USPS’s first-class monopoly is
being threatened, because FedEx and others have captured 90 percent of the overnight mail
business.Thus, USPS is losing business because of competition from overnight mail and
from new technologies.
© Frank Siteman Studio
Chapter 9 Monopoly 209 USPS has been fighting back, trying to leverage its monopoly power while
Chapter 9 Monopoly
209
USPS has been fighting back, trying to leverage its monopoly power while increasing ef-
ficiency. On the electronic front, USPS tried to offer online postage purchases, online bill-
paying service, and secure online document transmission service. But by December 2003,
these new products had been scrapped as failures. In more successful efforts, USPS has part-
nered with eBay to confirm delivery of auctioned items and expedite payments. USPS also
provides some local delivery service—the so-called “last mile”—for several major shippers
including DHL, Emery, and FedEx. Despite these efforts, changing technology and compe-
tition are eroding the government-granted monopoly power.
Sources: Rick Brooks, “New UPS Service Sends Packages Through the Post Office,” Wall Street Journal, 6 Novem-
ber 2003; Angela Kean, “Modernizing USPS,” Traffic World, 9 June 2003; Mark Fitzgerald, “USPS’ Snail-Mail
Spam,” Editor & Publisher, 14 April 2003; Rick Brooks, “Postal Service to Discontinue Online Bill-Payment Service,”
Wall Street Journal, 14 November 2003; and the USPS home page at http://www.usps.com.
Not all economists believe that monopolies, especially private monopolies, manage their
resources with any less vigilance than perfect competitors do. Some argue that because mo-
nopolists are protected from rivals, they are in a good position to capture the fruits of any
innovation and therefore will be more innovative than competitive firms are. Others believe
that if a private monopolist strays from the path of profit maximization, its share price will
drop enough to attract someone who will buy controlling interest and shape up the com-
pany.This market for corporate control is said to keep monopolists on their toes.
Price Discrimination
In the model developed so far, a monopolist, to sell more output, must lower the price. In
reality, a monopolist can sometimes increase profit by charging higher prices to those who
value the product more.This practice of charging different prices to different groups of con-
sumers is called price discrimination. For example, children, students, and senior citizens
often pay lower admission prices to ball games, movies, plays, and other events. Firms offer
certain groups reduced prices because doing so boosts profits. Let’s see how and why.
PRICE DISCRIMINATION
Conditions for Price Discrimination
To practice price discrimination, a firm’s product must meet certain conditions. First, the
demand curve for the firm’s product must slope downward, indicating that the firm is a
price maker—the producer has some market power, some control over the price. Second,
there must be at least two groups of consumers for the product, each with a different price
elasticity of demand.Third, the firm must be able, at little cost, to charge each group a dif-
ferent price for essentially the same product. Finally, the firm must be able to prevent those
who pay the lower price from reselling the product to those who pay the higher price.
Increasing profit by charging differ-
ent groups of consumers different
prices when the price differences
are not justified by differences in
production costs
A Model of Price Discrimination
Exhibit 9 shows the effects of price discrimination. Consumers are sorted into two groups
with different demand elasticities. For simplicity, we assume that the firm produces at a con-
stant long-run average and marginal cost of $1.00. At a given price, the price elasticity of de-
mand in panel (b) is greater than that in panel (a).Think of panel (b) as reflecting the de-
mand of college students, senior citizens, or some other group more sensitive to the price.
This firm maximizes profit by finding the price in each market that equates marginal revenue with
marginal cost. For example, consumers with a lower price elasticity pay $3.00, and those with
a higher price elasticity pay $1.50. Profit maximization results in charging a lower price to
210 Part 3 Market Structure and Pricing the group with the more elastic demand. Despite the
210
Part 3 Market Structure and Pricing
the group with the more elastic demand. Despite the price difference, the firm gets the same
marginal revenue from the last unit sold to each group. Note that charging both groups
$3.00 would eliminate any profit from that right-hand group of consumers, who would be
priced out of the market. Charging both groups $1.50 would lead to negative marginal rev-
enue from the left-hand group, which would reduce profit. No single price could generate
the profit achieved through price discrimination.
Examples of Price Discrimination
Let’s look at some examples of price discrimination. Because businesspeople face unpre-
dictable yet urgent demands for travel and communication, and because their employers pay
such expenses, businesspeople are less sensitive to price than are householders. In other
words, businesspeople have a less elastic demand for business travel and long-distance phone
use than do householders, so airlines and telephone services try to maximize profits by
charging business customers higher rates than residential customers.
But how do firms distinguish between customer groups? Telephone companies are able
to sort out customers by charging different rates based on the time of day. Long-distance
rates are often higher during normal business hours than during evenings and weekends,
when householders, who have a higher price elasticity of demand, make social calls.Airlines
distinguish between business and household customers based on the terms under which
tickets are purchased. Householders usually plan their trips well in advance and often spend
the weekend. But business travel is more unpredictable, more urgent, and seldom involves a
EXHIBIT
9
Price Discrimination with Two Groups of Consumers
A monopolist facing two groups of consumers with different demand elasticities may be able to practice price
discrimination to increase profit or reduce loss. With marginal cost the same in both markets, the firm charges
a higher price to the group in panel (a), which has less elastic demand than the group in panel (b).
(a)
(b)
$3.00
$1.50
LRAC, MC
1.00
LRAC, MC
1.00
D '
MR
D
MR'
0
400
Quantity per period
0
500
Quantity per period
Dollars per unit
Dollars per unit
Chapter 9 Monopoly 211 weekend stay.The airlines sort out the two groups by limiting discount fares
Chapter 9 Monopoly
211
weekend stay.The airlines sort out the two groups by limiting discount fares to travelers
who buy tickets well in advance and who stay over Saturday night.Airline tickets for busi-
ness class costs much more than for coach class.
Here’s another example of price discrimination: IBM wanted to charge business users of
its laser printer more than home users.To distinguish between the two groups, IBM decided
to slow down the home printer to 5 pages a minute (versus 10 for the business model).To
do this, they added an extra chip that inserted pauses between pages. 2 Thus, IBM could sell
the home model for less than the business model without cutting into sales of its business
model.
Here’s a final example. Major amusement parks, such as Disney World and Universal Stu-
dios, distinguish between local residents and out-of-towners when it comes to the price of ad-
mission. Out-of-towners typically spend a substantial amount on airlines and lodging just to
be there, so they are less sensitive to the admission price than are local residents.The problem
is how to charge a lower price to locals.The parks do this by making discount coupons avail-
able at local businesses, such as dry cleaners, which vacationers are less likely to visit.
Perfect Price Discrimination: The Monopolist’s Dream
The demand curve shows the marginal value of each unit consumed, which is also the max-
imum amount consumers would pay for each unit. If the monopolist could charge a differ-
ent price for each unit sold—a price reflected by the height of the demand curve—the
firm’s marginal revenue from selling one more unit would equal the price of that unit.Thus,
the demand curve would become the firm’s marginal revenue curve.A perfectly discrim-
inating monopolist would charge a different price for each unit sold.
In Exhibit 10, again for simplicity, the monopolist is assumed to produce at a constant
average and marginal cost in the long run.A perfectly discriminating monopolist, like any
producer, would maximize profit by producing the quantity at which marginal revenue
equals marginal cost. Because the demand curve is now the marginal revenue curve, the
profit-maximizing quantity occurs where the demand, or marginal revenue, curve intersects
the marginal cost curve, identified at point e in Exhibit 10. Price discrimination is a way of
increasing profit.The area of the shaded triangle aec defines the perfectly discriminating mo-
nopolist’s economic profit.
PERFECTLY DISCRIMINATING
MONOPOLIST
A monopolist who charges a differ-
ent price for each unit sold; also
called the monopolist’s dream
By charging a different price for each unit sold, the perfectly discriminating monopolist is able to
convert every dollar of consumer surplus into economic profit.Although this practice may seem un-
fair to consumers, perfect price discrimination gets high marks based on allocative effi-
ciency. Because such a monopolist does not have to lower the price to all customers to sell
Reading It R ight
more, there is no reason to restrict output. In fact, because this is a constant-cost industry, Q
is the same quantity produced in perfect competition (though in perfect competition, the
triangle aec would be consumer surplus, not economic profit).As in the perfectly competi-
tive outcome, the marginal benefit of the final unit produced and consumed just equals its
marginal cost.And although perfect price discrimination yields no consumer surplus, the
total benefits consumers derive just equal the total amount they pay for the good. Note also
that because the monopolist does not restrict output, there is no deadweight loss.Thus, per-
fect price discrimination enhances social welfare when compared with monopoly output in
the absence of price discrimination. But the monopolist reaps all net gains from production,
while consumers just break even on the deal because their total benefit equals their total
cost.
What’s the relevance of the fol-
lowing statement from the Wall
Street Journal: “Any merchant
would love to sell a product at the
highest price each customer will
pay.”
2. Carl Shapiro and Hal Varian, Information Rules: A Strategic Guide to the Network Economy (Boston: Harvard
Business School Press, 1999), p. 59.
212 Part 3 Market Structure and Pricing EXHIBIT 10 a Perfect Price Discrimination Profit If a
212
Part 3 Market Structure and Pricing
EXHIBIT
10
a
Perfect Price
Discrimination
Profit
If a monopolist can charge a different
price for each unit sold, it may be able
to practice perfect price discrimination.
By setting the price of each unit equal
to the maximum amount consumers are
willing to pay for that unit (shown by the
height of the demand curve), the mo-
nopolist can earn a profit equal to the
area of the shaded triangle. Consumer
surplus is zero. Ironically, this outcome
is efficient because the monopolist has
no incentive to restrict output.
Long-run
e
c
average cost
= marginal cost
D = Marginal
revenue
0
Q
Quantity per period
Examples of attempts to capture consumer surplus include pricing schemes for Internet
service, cable television, and cellular phone service. For example, a cellular phone service
offers several pricing alternatives, such as (1) price per minute with no basic fee, (2) a flat
rate for the month plus a price per minute, and (3) a flat rate for unlimited calls.These alter-
natives allow the company to charge those who use fewer minutes more per minute than
those who call more frequently. Such suppliers are trying to convert some consumer surplus
into profit.
Conclusion
Pure monopoly, like perfect competition, is not that common. Perhaps the best examples
are firms producing patented items with unique characteristics, such as certain prescription
drugs. Some firms may have monopoly power in the short run, but the lure of economic
profit encourages rivals to hurdle seemingly high entry barriers in the long run. Changing
technology also works against monopoly in the long run. For example, the railroad monop-
oly was erased by the interstate highway system.AT&T’s monopoly on long-distance phone
service crumbled as microwave technology replaced copper wire.The U.S. Postal Service’s
monopoly on first-class mail is being eroded by overnight delivery, fax machines, and email.
De Beers is losing its grip on the diamond market.And cable TV service is losing its local
monopoly to technological breakthroughs in fiber-optics technology, wireless broadband,
and the Internet.
Although perfect competition and pure monopoly are relatively rare, our examination of
them yields a framework to help understand market structures that lie between the two ex-
tremes.As we will see, many firms have some degree of monopoly power—that is, they face
downward-sloping demand curves. In the next chapter, we will consider the two market
structures that lie in the gray region between perfect competition and monopoly.
Dollars per unit
Chapter 9 Monopoly 213 SUMMARY 1. A monopolist sells a product with no close substitutes. Short-run
Chapter 9 Monopoly
213
SUMMARY
1.
A monopolist sells a product with no close substitutes.
Short-run economic profit earned by a monopolist can
persist in the long run only if the entry of new firms is
blocked.Three barriers to entry are (a) legal restrictions,
such as patents and operating licenses; (b) economies of
scale over a broad range of output; and (c) control over a
key resource.
4.
In the short run, a monopolist, like a perfect competitor,
can earn economic profit but will shut down unless price
at least covers average variable cost. In the long run, a mo-
nopolist, unlike a perfect competitor, can continue to earn
economic profit as long as entry of other firms is blocked.
5.
2.
Because a monopolist is the sole supplier of a product
with no close substitutes, its demand curve is also the
market demand curve. Because a monopolist that does not
price discriminate can sell more only by lowering the
price for all units, marginal revenue is less than the price.
Where demand is price elastic, marginal revenue is posi-
tive and total revenue increases as the price falls.Where
demand is price inelastic, marginal revenue is negative and
total revenue decreases as the price falls.A monopolist
will never voluntarily produce where demand is inelastic
because charging a higher price would increase total
revenue.
Resources are usually allocated less efficiently under mo-
nopoly than under perfect competition. If costs are simi-
lar, the monopolist will charge a higher price and supply
less output than will a perfectly competitive industry. Mo-
nopoly usually results in a deadweight loss when com-
pared with perfect competition because the loss of con-
sumer surplus exceeds the gains in monopoly profit.
6.
To increase profit through price discrimination, the mo-
nopolist must have at least two identifiable groups of cus-
tomers, each with a different price elasticity of demand at
a given price, and must be able to prevent customers
charged the lower price from reselling to those charged
the higher price.
7.
3.
If the monopolist can at least cover variable cost, profit is
maximized or loss is minimized in the short run by find-
ing the output rate that equates marginal revenue with
marginal cost.At the profit-maximizing quantity, the price
is found on the demand curve.
A perfect price discriminator charges a different price for
each unit of the good sold, thereby converting all con-
sumer surplus into economic profit. Perfect price discrim-
ination seems unfair because the monopolist “cleans up,”
but this approach is as efficient as perfect competition be-
cause the monopolist has no incentive to restrict output.
QUESTIONS
FOR
REVIEW
1.
(Barriers to Entry) Complete each of the following sen-
tences:
3.
( Case S tudy:
Is a Diamond Forever?) How did the
De Beers cartel try to maintain control of the price in the
diamond market? How has this control been threatened?
a.
A
U.S. _______
awards inventors the exclusive right
to production for 20 years.
4.
b.
Patents and licenses are examples of government-
imposed
that prevent entry into an industry.
(Revenue for the Monopolist) How does the demand curve
faced by a monopolist differ from the demand curve faced
by a perfectly competitive firm?
c.
When economies of scale make it possible for a single
firm to satisfy market demand at a lower cost per unit
than could two or more firms, the single firm is con-
sidered a _______.
5.
(Revenue for the Monopolist) Why is it impossible for a
profit-maximizing monopolist to choose any price and
any quantity it wishes?
d.
A potential barrier to entry is a firm’s control of a(n)
6.
______
critical to production in the industry.
2.
(Barriers to Entry) Explain how economies of scale can be a
barrier to entry.
(Revenue Schedules) Explain why the marginal revenue
curve for a monopolist lies below its demand curve, rather
than coinciding with the demand curve, as is the case for a
perfectly competitive firm. Is it ever possible for a monop-